Posts Tagged ‘financial crisis’

2) London’s mayor wants to start a recycling bank program that gives people shopping vouchers for their recyclables.

3) Another plug this past weekend for the automatic tax return. California says it costs $2.59 to process a paper return, but only 34 cents to process its version of the automatic tax return, ReadyReturn. The makers of Turbo Tax have been trying to end the program, most recently this fall.

4) Calorie postings at Starbucks led to lower calorie consumption by six percent–except around the holidays. Hat tip: Farnam Street.

5) Will Obama mention the automatic IRA in his State of the Union speech Wednesday?

In a new column in the Financial Times, Richard Thaler expands on some earlier thoughts about the efficient market hypothesis by way of a review of Justin Fox’s new book, The Myth of the Rational Market.

What lessons should we draw from (the last two years)? On the free lunch component there are two. The first is that many investments have risks that are more correlated than they appear. The second is that high returns based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist. On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be “right”, then these bubbles would not occur. But they have, so what are we to do?

If Chicago were, say, the world of finance, the efficient market hypothesis would be the Willis Tower. That’s the old Sears Tower, for those who don’t know. As a hulking steel pillar looming over its surroundings, the theory claims that a financial asset’s price reflects every bit of available information related to its value. It is the foundation by which lots of economists tell regular investors they can’t possibly beat the market. After all, how can you figure out a better value for an asset when all the information about it is already wrapped into the current price?

In the world of the EMH, as it is known, bubbles are nothing to seriously worry about because prices cannot deviate from proper valuations for too long. But in the wake of last fall’s stock market collapse, fully embracing the efficient market hypothesis can be a scary proposition – a bit like stepping out on “the Ledge” at the Willis Tower. (An absolute must if you’re in Chicago, by the way.) The events of the past year have sparked a rich debate between behavioral economists and EMH-ers over the the EMH’s validity that is nicely chronicled in this week’s Economist.

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”. (Myron) Scholes, however, insists that the efficient-market paradigm is not dead: “To say something has failed you have to have something to replace it, and so far we don’t have a new paradigm to replace efficient markets.” The trouble with behavioural economics, he adds, is that “it really hasn’t shown in aggregate how it affects prices.”

Yet EMH-ers and behaviouralists are increasingly asking the same questions and drawing on each other’s ideas. For instance, Mr Thaler concedes that in some ways the events of the past couple of years have strengthened the EMH. The hypothesis has two parts, he says: the “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

Newsweek asks whether certain people are wired to make poor financial decisions by simplifying complex problems. A study by some cognitive neuroscientists suggests yes, and says this group contains many extroverts who are 1) optimistic about their lives and 2) impulsive.

In the past, however, these optimistic simplifiers would have been better off because mortgages and even credit card rules were simpler, says Richard Thaler, a behavioral economist at the University of Chicago and the coauthor of Nudge: Improving Decisions About Health, Wealth, and Happiness. In the late-’70s/early-’80s, when the 30-year, fixed-rate mortgage was pretty much the only loan option, a “rule of thumb” worked well: You looked for one number, the annual percentage rate, decided if you could afford it and then signed on the dotted line (or walked away). “Once mortgages got very, very complicated,” Thaler says, “doing the correct analysis required having a Ph.D. in economics”-and simplifying under those circumstances became dangerous.

Reader Christopher Daggett points to a New York Times piece about the recent jump in vasectomies related to the economic downturn.

In Southern California, Planned Parenthood says that compared with last year’s first quarter, requests for vasectomies were up more than 30 percent in the first three months of this year.

“I’ve been in practice for 30 years, and I’ve never seen a spike like this,” Dr. Goldstein said. “Many of my clients work in finance and say they feel anxious about the expense of an added child.”

Daggett finds this behavior peculiar. “To avoid the costs of pregnancy in an economic downturn, (men) opt for a costly procedure that is even more costly to reverse,” he writes. “Many are not getting the most bang for their buck–there are cheaper alternatives for birth control.” Only if the objective is to become permanently sterile, do vasectomies make economic sense. But Daggett thinks most men are overreacting, opting for the procedure out of an availability bias for miserable recent economic news, and ignoring the long term cycles of economic growth.

It’s hard to disagree with this assessment. But there is a behavioral economic explanation for why a man might opt for a vasectomy in a period of economic turbulence. Usually, behavioral economic explanations tend toward human mistakes. But in this case, men might not be making mistakes at all. Huh?

1) Richard Thaler talked with NPR’s Morning Edition about whether government messages about the economy affect consumer behavior? Does economic cheerleading make a difference? (The clip runs about 4 minutes.)

A listener then posts this terrific haiku that sums up Thaler’s message:

In debt? Thrift will help.
Got money? Spend it freely.
Good for all of US.

(Please note that when read aloud, US is one syllable. On paper of course, the implied U.S. is also there.)

2) Thaler takes part in an interesting To the Point roundtable on the place of Nudge and behavioral economics in the Obama campaign and administration. One example is advice from behavioralists to campaign field directors in the final weeks of the campaign was to tweak the voter message to say, “A record turnout is expected.” The most effective motivator for getting people to vote is the expectation that others will vote too. Also taking part to discuss criticisms from the left and right were writers from Time, the New Republic, and Reason magazine. (The conversation lasts about 35 minutes. It starts at about 7 minutes and 45 seconds.)

Nudge readers know all about the two-sides of the human brain theory, System 1 the intuitive side prone to making snap decisions based on emotions and heuristics, and System 2, which relies on slow, cool logic. How many of our decisions each side is responsible for may not be knowable, but a financial psychologist named Brad Klontz is willing to make an estimate.

“It’s a scary time,” Mr. Klontz said. “The emotional part of the brain makes 80 percent of the decisions, and when it really gets activated, it shuts off rational decision-making. It’s lemmings going over a cliff.”

Question: Should we become a nation of savers like Japan where the savings rate has been consistently over 10 percent in the last few decades, hitting a high of 18 percent in 1981. (It is dropping now.)

Thaler: “I think the most we can hope for is that we become less a nation of debtors. The national savings rate for the last few years has been essentially zero. In December it jumped to 2 or 3 percent. This is not Japan…I think we are going to see a period of a few years of retrenchment in consumer spending and that may prolong this recession…But that is necessary. We can’t sustain an economy where we spend $102 out of every $100 we make.”

Question: Do periods of economic crisis lead to permanent behavioral changes?

Thaler: “If you look at the data say in 1980, people who were going into retirement at that time had no mortgage debt to speak of. People would take out a mortgage and they would pay it off. And certainly in my parents generation, paying off the mortgage was one of the big goals in life. That seems to have completed vanished in the last 20 years. You see people in their sixties taking out new 30-year mortgages. So I think we do need to establish a new, or old if you will, set of norms where people do strive to pay off their mortgages before they retire so at least they have their home equity to help finance their retirement.”

In financial markets, where evidence of irrationality has been abundant lately, (Thaler) says he would increase regulations, but very carefully. There’s no evidence, (Thaler) said, that regulators could actually determine appropriate leverage for specific investments, for example, and “heavy-handed regulation” could shut down financial markets and weaken the economy further.

“The trick is to try and figure out a way of forcing these firms to disclose more of what they’re doing without giving away so much that they can no longer make a living,” he said. Such information would help individuals decide whether to invest in the funds, and would help regulators assess overall risk imposed on the financial system and the economy. In addition, he said, disclosure itself often has a salutary effect on behavior because people tend to be mindful of the opinions of others.

Thaler calls Sunstein the “Nudger in Chief.” Read the full piece in the New York Times.

Disclaimer

The Nudge blog is associated with the book Nudge: Improving Decisions about Health, Wealth, and Happiness, by Richard Thaler and Cass Sunstein. Sunstein is currently the Administrator of the White House Office of Information and Regulatory Affairs and has no affiliation with the Nudge blog.